Monday, September 10, 2012

This chart shows the yield on 2-yr Treasuries, currently 0.25%. It's about as low as it's ever been, and that means that the bond market holds out very little hope for any meaningful growth in the U.S. economy for the next several years. To understand why that is the case, consider simply that the 2-yr Treasury yield is equivalent to the market's expectation for what the Federal funds rate—currently 0.16%—will average over the next two years. Market arbitrage ensures that this is so, because investors on average must be indifferent to holding cash at an overnight rate for the next two years (earning whatever the Fed funds rate adds up to), or investing in a 2-yr Treasury note and locking in the current rate for the next two years.

Expectations are running high that the Fed will engage in another round of quantitative easing given the weak growth in jobs and the generally weak nature of the U.S. economy. But even strong expectations of QE3 have failed to increase the market's confidence in the future. What they have done, however, is to increase future inflation expectations, as seen in the chart below:

The 5-yr, 5-yr forward implied inflation expectation embedded in TIPS and Treasury prices has reached 2.8%, up from 2.0% about one year ago.

In other words, the bond market believes the economy will remain very weak despite more quantitative easing, and that inflation will tend to rise nonetheless. The bond market vigilantes are saying that more Fed ease won't help the economy, but it could hurt via higher inflation. The gold market agrees, having sent gold prices up 8% in the past few weeks. All of this should give the Fed pause. We already have $1.5 trillion of excess reserves; adding more won't make the economy stronger.

7 comments:

Scott is correct when he says that the "bond market holds out very little hope for any meaningful growth in the U.S. economy for the next several years." I tend to agree with the bond markets. We are living in a period of documented pessimism, which spells b-u-y for investors. Now is the time to convert world-class skills into premium wages for investment into equity bargains available everywhere. Investors with a 30-year plus horizon will be the big winners. Anyone trying to "get rich quick" during the coming decade (or two) is lost. I urge everyone in America to find money to invest now. If that means taking on a second or third job, delaying marriage, or selling depreciating assets, so be it. Find the money and invest that money now in equities selling at bargain prices. We are in a buy window of opportunity -- in fact, the opportunity of a lifetime!

BAA yield spreads are still somewhat elevated, which implies a decent risk of a slowdown, but not a disaster. I think BAA yields are consistent with the overall message of the bond market: very slow growth for a long time, with some concern about higher inflation. Higher inflation is good for corporate bonds, actually, because that improves corporate cash flow and higher inflation is generally good for those with lots of debt.